Fed May Be More Cautious on Tapering

Paying too much attention to the minutes of July’s Federal Open Market Committee meeting, to be released well after Europe’s markets have closed Wednesday, could be a mistake.

Instead of rising on expectations that the minutes will hint at the Fed slicing as much as $20 billion from its $85 billion monthly asset purchases from September–as some economists expect–the dollar has been falling.

That is because, despite what the minutes record of a meeting held three weeks ago, the Fed is likely to be cautious given what has happened since then.

Even three weeks ago, in the statement after the July 30-31 meeting, the U.S. central bank was voicing concern about the impact ‘tapering’ talk was having on U.S. interest rates.

And since then, those interest rates have risen further. The 10-year Treasury yield, which was down at 1.6% early in May, reached a new recent high of 2.90% earlier this week.

The result?

Increased fears that more expensive mortgages will bring the recent recovery in the U.S. housing market to a shuddering halt.

Its debt crisis may have receded for now but the rise in European borrowing costs in the wake of higher Treasury yields risks creating a fresh debt crisis.

But first let’s look at the U.S.

The housing market has yet to show any serious signs of fallout from the rise in Treasury yields, but, as mortgage rates continue to rise, it will doubtlessly be only a matter of time before it does.

Geoffrey Yu, a strategist at UBS, put it this way: “Higher mortgage or even general debt servicing costs dampen the bottom line of households, and constraints on the housing recovery could affect the wider recovery.”

Given the fragility of that recovery, the Fed is more likely to err on the side of caution.

Then there is the wholesale pullout of funds from emerging markets, tipping those countries with large current-account deficits into turmoil.

Diving exchange rates for the Indian rupee and the Indonesian rupiah in particular are shaking confidence in the global recovery and raising fears that another major crisis could be about to envelop the region.

Of course, the Fed will set its policy for the benefit of the U.S. economy and not for the rest of the world.

Nonetheless, the U.S. economy and the country’s financial system will not be immune if a fresh crisis erupts in the euro zone or in Asia and so, as the dollar’s recent weak performance suggests, the Fed may yet taper its policy more carefully than many in the market expect the minutes to suggest.